US dollar’s reserve currency status no longer means less risk

By Martin Feldstein

The US’ current fiscal and monetary policies are unsustainable. The US government’s net debt as a share of GDP has doubled in the past five years and the ratio is projected to be higher a decade from now, even if the economy has fully recovered and interest rates are in a normal range.

An aging US population will cause social benefits to rise rapidly, pushing the debt to more than 100 percent of GDP and accelerating its rate of increase.

Although the US Federal Reserve and foreign creditors like China are now financing the increase, their willingness to do so is not unlimited.

Likewise, the Fed’s policy of large-scale asset purchases has increased commercial banks’ excess reserves to unprecedented levels (approaching US$2 trillion) and has driven the real interest rate on 10-year Treasury bonds to an unprecedented negative level. As the Fed acknowledges, this will have to stop and be reversed.

While the future evolution of these imbalances remains unclear, the result could eventually be a sharp rise in long-term interest rates and a substantial fall in the dollar’s value, driven mainly by foreign investors’ reluctance to continue expanding their holdings of US debt.

US investors, fearing an unwinding of the fiscal and monetary positions, might contribute to these changes by seeking to shift their portfolios to assets of other countries.

While I share these concerns, others frequently rely on two key arguments to dismiss the fear of a run on the dollar: The dollar is a reserve currency and it carries fewer risks than other currencies. Neither argument is persuasive.

Consider first the claim that the dollar’s status as a reserve currency protects it, because governments around the world need to hold dollars as foreign exchange reserves. The problem is that foreign holdings of dollar securities are no longer primarily “foreign exchange reserves” in the traditional sense.

In earlier decades, countries held dollars because they needed to have a highly liquid and widely accepted currency to bridge the financing gap if their imports exceeded their exports. The obvious candidate for this reserve fund was US Treasury bills.

However, since the late 1990s, countries like Taiwan, South Korea and Singapore have accumulated very large volumes of foreign reserves, reflecting both export-driven growth strategies and a desire to avoid a repeat of the speculative currency attacks that triggered the 1997-1998 Asian financial crisis. With each of these countries holding more than US$200 billion in foreign-exchange holdings — and China holding more than US$3 trillion — these are no longer funds intended to bridge trade-balance shortfalls. They are major national assets that must be invested with attention to yield and risk.

So, although dollar bonds and, increasingly, dollar equities are a large part of these countries’ sovereign wealth accounts, most of the dollar securities that they hold are not needed to finance trade imbalances.

Even if these countries want to continue to hold a minimum core of their portfolios in a form that can be used in the traditional foreign-exchange role, most of their portfolios will respond to their perception of different currencies’ risks.

In short, the US no longer has what Valery Giscard d’Estaing, as France’s finance minister in the 1960s, accurately called the “exorbitant privilege” that stemmed from having a reserve currency as its legal tender.